Chapter 19 The Firm The basic economic problem is scarcity. Human wants are unlimited. Resources are limited. The basic goal in dealing with the problem of scarcity is to produce as much consumer satisfaction as possible with the limited resources available. To produce as much consumer satisfaction as possible with the limited resources available, society must use its limited resources as efficiently as possible. Whatever is produced must be produced with as few resources as possible (at the lowest opportunity cost). Most production in a developed economy takes place through firms; either business firms or nonprofit firms. Firm – an entity that employs resources to produce goods and services. Most resources (labor, land, capital, entrepreneurship) are owned by households. For instance, each person owns his or her own labor. Potentially, all production could take place at the household level. A great deal of production does take place at the household level; e.g. child care, food preparation, clothes washing, etc. But most production takes place through firms. Why does most production take place through firms? Firms and Efficiency Firms are often the best way to organize the limited resources for production. For many types of production, firms can produce more efficiently (at lower cost) than households. Example 1: Juanita produces some of the goods and services that she consumes using her own resources. She cooks her own meals, cleans her own house, washes her own hair, etc. But Juanita also purchases goods and services from firms. She pays a stylist to cut her hair rather than cutting it herself. She buys food (e.g. fruits and vegetables) at the supermarket rather than growing her own garden. She buys various manufactured goods (e.g. a new refrigerator) rather than making them herself. Most of the goods and services that she consumes are produced by firms, because she finds it cheaper to buy the goods than to produce them herself. Firms and Reduced Transaction Costs The efficiency advantage that firms have over household production may occur because firms can reduce transaction costs. Transaction costs – the costs of bringing buyers and sellers together for exchanges. When two parties voluntarily engage in a trade, both parties expect to benefit from the trade. But if the transaction costs of carrying out the trade are large, the transaction costs may outweigh the benefit of the trade. A firm may be able to reduce transaction costs, creating more opportunities for mutually beneficial exchanges. Example 2A: Juanita, who lives in Tulsa, Oklahoma wants three pounds of bananas and is willing to pay 80¢ per pound. Lucio, a banana farmer in Ecuador, is willing to sell bananas for 20¢ per pound. But the transaction costs of carrying out the exchange directly between Juanita and Lucio would outweigh the benefit of the trade. Firms, such as wholesale distributors and supermarkets, can reduce transaction costs and make it possible for Juanita to purchase bananas grown by Lucio. Example 2B: The transaction costs of buying groceries would be very high if the consumer tried to buy directly from each producer. This might involve a drive to the nearest dairy farm to purchase milk, a drive to the nearest bakery to purchase bread, a drive to the nearest orchard to purchase apples, a flight to Ecuador to purchase bananas, etc. Instead, supermarkets make a variety of groceries available at low transaction costs. FOR REVIEW ONLY - NOT FOR DISTRIBUTION 19 - 1 The Firm